Defined Contribution Plans
Conventional 401(k) Plans
401(k) Plans are popular among the companies
that would like to provide a retirement plan for their employees
that allow the
employees to defer part of their own salary (up to regulated
limits) on a pre-tax basis into the plan and contribute toward
their own retirement. In general, there is no limitation as
to the size a company must be in order to take advantage of the
use of a 401(k) Plan.
Additionally, they can be set up to allow
the employer to choose whether or not they contribute on the
employees’ behalf.
Typical types of employer contributions that may be included
are matching contributions and/or profit sharing contributions.
Employer contributions are discretionary and are flexible in
terms of the different formulas that may be utilized in determining
the contribution level.
Generally, there are 3 potential money
types (sources) in a conventional 401k Plan; salary deferral
(401(k), employer matching contribution
and employer profit sharing contribution. Other money types
are available provided that the plan document used supports them.
(ie. IRA Rollovers, Employee after-tax contributions, Qualified
non-elective contributions (QNEC) Profit Sharing Plans
Given the discretionary nature of the contribution requirements,
Profit Sharing Plans are popular among businesses that may
not know year-to-year what their bottom line may yield.
Typically,
the only money type (source) utilized in which periodic deposits
are made in these types of plans are the discretionary
employer profit sharing contributions. As with conventional
401(k) Plans, other money types are available provided that the
plan
document used supports them.
These plans also offer plan sponsors
great flexibility in determining the eligibility, vesting and
loan provisions, among others,
used in the plan, which allows them to tailor the plan to
fit their
business needs.
Due to the changes in law under EGTRRA, for plan
years beginning after January 1, 2002, the limitations on contributions
for profit
sharing plans allow employers to make contributions up to 25%
of the eligible payroll for the company. The breakdown of the
contributions between the eligible employees is typically accomplished
on a pro-rata basis (ie. 10% of pay to each eligible employee)
unless some other advanced technique such as cross-testing
is incorporated. (Cross-testing discussed below)

Profit Sharing
401(k)
Profit Sharing 401(k) Plans are just as
the name implies. These plans combine the benefits of a conventional
401(k) Plan with
the benefits derived from a Profit Sharing Plan into one plan,
with all the same rules applying. These plans are extremely
popular for the businesses that have the desire to give the employees
flexibility to contribute toward their own retirement while
still
allowing the employer the ability to share in the profitability
of the company, on a discretionary basis, as revenue allows.
As with Profit Sharing Plans, advanced techniques and formulas
may be incorporated to allow for greater flexibility in terms
of how much an employer contributes to each eligible employee.

Money
Purchase Plans
Given the mandatory nature of the contribution
requirements for Money Purchase Pension Plans, historically
they have been utilized
by businesses that have had very consistent profits year-to-year
and/or by companies that required contributions in excess of
the contributions limits that used to be allowable in a Profit
Sharing Plan.
Prior to EGTRRA, Profit Sharing Plans were limited
to 15% of pay while Money Purchase Plans were 25% of pay. Therefore,
for
the companies that desired contributions in excess of the 15%
of pay maximum of a Profit Sharing Plan, a second plan was
put in place (Money Purchase Plan) that allowed them to contribute
the additional 10% (25%-15%). However, with the advent of EGTRRA
and the increase in the Profit Sharing Plan limit to 25% of
pay,
the Money Purchase Plan has dropped off in popularity and has
all but become obsolete in most instances due to its mandatory
nature for contributions and its more restrictive rules relative
to the Profit Sharing Plan.

Defined Benefit Plans
Unlike the Defined Contribution Plans (DC
Plans) listed above, where the plan defines the contribution
that is made on behalf
of an eligible employee, a Defined Benefit Plan (DB Plan)
defines and promises a specific benefit that an eligible
employee will
receive at some point in the future, typically at retirement.
This promise, or defined benefit, is determined regardless
of market conditions or contribution requirements of the
employer.
A major advantage to DB Plans is that an employer is allowed
to tax deduct whatever contribution is required to keep the
plan fully funded in order to support the benefits of the plan.
It
is important to note that because of the required costs to
fund the plan on a regular basis, some companies have found themselves
unable to keep up with the costs associated with keeping a
DB
Plan fully funded. This has shown to be especially true among
large corporations who have recently moved toward the discretionary
plans like Profit Sharing and/or 401(k) Plans.
However, on the
other side of the coin, due to the new rules under EGTRRA,
DB Plans have recently become much more popular
again, especially with smaller companies.
These Plans are very
beneficial among businesses with owners and key employees nearing
retirement age who desire larger contributions
than a DC Plan will allow. This is mainly due to the fact that
older employees have less time to retire than younger employees.
Therefore, if the same benefit is given to both the younger
employees and older employees alike, the time to accumulate that
benefit
is much less with the older employee, hence why the contribution
for that older employee will tend to be higher, in some cases
in excess of 100% of eligible compensation.

Cash Balance Plans
A cash balance plan is a hybrid, part defined benefit plan – part
defined contribution (profit sharing) plan. It is a defined benefit
plan (DB Plan) in that the contributions are calculated using
funding methods derived from DB Plans. However, it is a profit
sharing plan (DC Plan) in that the ‘defined benefit’ for
a participant is converted to a ‘theoretical account balance’,
a form that is generally more understandable by the general public.
This actuarially-designed defined benefit plan determines an
employee’s benefit by reference to the employee’s “account
balance” or theoretical account that is established using
a method similar to how a profit sharing plan allocates contributions
and earnings to a participant. With a cash balance plan, each
employee’s theoretical account is the sum of contributions
for prior plan years plus interest adjustments made to the
participant’s
account through normal retirement age.
One creative cash balance
plan design cross-tests a participant’s
contributions and account balance similar to an age-based,
cross-tested profit sharing 401(k) plan. The benefit of this
plan design is
that selected highly compensated employees or key employees
can receive an allocation in excess of the profit sharing plan
limitation
of $40,000 annually. Reference to the preamble to the proposed
regulations for cash balance plans dated September 21, 1991
supports this view:
Preamble to Proposed Regulations, September 21, 1991.
A cash
balance plan satisfies Code Section 401(a)(4) if it provides
benefit accruals that are non-discriminatory under
the general
test for defined benefit pension plans, or if it is non-discriminatory
with respect to an equivalent amount of contributions under
the cross-testing rules, or if it meets a special safe harbor
for
cash balance plans.
Enforcement of the cash balance amended
and proposed regulations have recently been suspended by the
government as a result
of criticism from Congress, the practitioner community,
and the
courts. The criticism mainly relates to plan conversions
from traditional defined benefit plans to cash balance
plans, though
new cash balance plan Favorable Determination Letters continue
to be issued by the Internal Revenue Service.

Target Benefit Plans
Target Benefit Plans are a mix between a
Defined Benefit Plan and a Money Purchase Plan. This plan is
designed primarily
to allow for each eligible employee to have an individual
account funded solely by the mandatory employer contributions
made
each year. The contributions are based on an actuarially
generated formula or targeted benefit, similar to a Defined Benefit
Plan,
however, the actual benefit received when an eligible employee
retires is calculated and based upon the actual balance that
resides in the employee’s account at the time of retirement
and not the benefit that the plan was funding for.

Optional
Features
Safe Harbor
Many employers are now adopting safe harbor 401(k) or safe harbor
profit sharing 401(k) plans. One of the primary reasons is that
EGTRRA (The Economic Growth Tax Relief and Recovery Act) increased
the maximum salary deferrals allowable while not increasing the
Safe Harbor Contribution rate enacted by the Small Business Job
Protection Act of 1996. The bottom line is that both the safe
harbor non-elective and safe harbor matching contribution methods
bring future higher benefits for highly compensated employees
while at the same time continuing to provide a substantial benefit
for the non-highly compensated rank & file employees.
Big
companies previously using negative salary deferral elections
to help satisfy the Actual Deferral Percentage (“ADP”)
test have, in many cases, found safe harbor matching contributions
to be a useful way to allow highly compensated employees to
participate in the plan on a substantive level while keeping
controls on
costs .
Research has also established that smaller companies
have been using the safe harbor non-elective profit sharing
contribution
method to eliminate the high cost of 401(k) Anti-Discrimination
Testing; while satisfying the top-heavy minimum contribution
requirements and maximizing contributions allowable to highly
compensated employees. It is our opinion that using either
method provides an efficient mechanism to satisfy ADP testing
and increase
benefits to highly compensated employees without adversely
affecting the non-highly compensated employees.
Click here
to see more regarding how the safe harbor formulas are calculated.

Cross Testing
Cross-testing, sometimes referred to
as Tiering, is an advanced technique often used when
employers desire the flexibility to
provide different contribution formulas for different
classifications of employees.
This advanced technique
may be incorporated and applied to both Defined Contribution
(Profit Sharing, 401(k),
Money Purchase, etc.) and Defined Benefit Plans
alike.
One of the most attractive
features of these types of designs is that it allows the employer
to design a plan that more closely
meets the needs of the business. No longer are you required
to allocate contributions proportionately (same % of pay to each)
to all employees based on their salary. A disparity in contributions
now may be designed into the plan provided that certain testing
requirements are met. Employers are freer to decide how the
contributions
should be allocated, provided they are based on any reasonable
classification. (ie. job description, years of service, salary
range, department profitability, etc.)

Age Based
Code Section 401(a)(4) allows testing of a defined contribution
(DC) plan (profit sharing 401(k), money purchase, and target
benefit plans) for discrimination on a benefits basis. This allows
a plan sponsor to take into consideration when allocating contributions,
a participant’s age and salary. The underlying premise
is that a younger participant receiving the same contribution
as an older participant is actually getting a greater benefit
than the older participant since the contribution made for the
younger participant will, at normal retirement, have had the
opportunity to compound longer since it is a longer period of
time until they reach normal retirement age. Based on a one percent
of paid benefit, this method provides for contributions based
on age and pay that are non-discriminatory. The age-weighted
plan is a non-safe harbor plan and is tested yearly for non-discrimination
using the Code Section 401(a)(4) general test.

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